Important Information on Penny Stocks
Use Caution When Investing in Penny Stocks
Disclosures to you. Under penalty of federal law, your brokerage firm must tell you the following information at two different times-before you agree to buy or sell a penny stock, and after the trade, by written confirmation:
The market for penny stocks. Penny stocks usually
are not listed on an exchange or quoted on the NASDAQ system.
Instead, they are traded between dealers on the telephone in the
"over-the-counter" market. The NASD's OTC Bulletin Board also will
contain information on some penny stocks. At times, however, price
information for these stocks is not publicly available.
Market domination. In some cases, only one or two
dealers, acting as "market makers," may be buying and selling a
given stock. You should first ask if a firm is acting as a
broker (your agent) or as a dealer. A dealer buys
stock itself to fill your order or already owns the stock. A
market maker is a dealer who holds itself out as ready to
buy and sell stock on a regular basis. If the firm is a market
maker, ask how many other market makers are dealing in the stock
to see if the firm (or group of firms) dominates the market. When
there are only one or two market makers, there is a risk that the
dealer or group of dealers may control the market in that stock
and set prices that are not based on competitive forces. In recent
years, some market makers have created fraudulent markets in
certain penny stocks, so that stock prices rose suddenly, but
collapsed just as quickly, at a loss to investors.
Mark-ups and mark-downs. The actual price that the
customer pays usually includes the mark-up or mark-down. Markups
and markdowns are direct profits for the firm and its salespeople,
so you should be aware of such amounts to assess the overall value
of the trade.
The "spread." The difference between the bid and
offer price is the spread. Like a mark-up or mark-down, the spread
is another source of profit for the brokerage firm and compensates
the firm for the risk of owning the stock. A large spread can make
a trade very expensive to an investor. For some penny stocks, the
spread between the bid and offer may be a large part of the
purchase price of the stock. Where the bid price is much lower
than the offer price, the market value of the stock must rise
substantially before the stock can be sold at a profit. Moreover,
an investor may experience substantial losses if the stock must be
sold immediately.
Example: If the bid is $0.04 per share and the offer
is $0.10 per share, the spread (difference) is $0.06, which
appears to be a small amount. But you would lose $0.06 on every
share that you bought for $0.10 if you had to sell that stock
immediately to the same firm. If you had invested $5,000 at the
$0.10 offer price, the market maker's repurchase price, at $0.04
bid, would be only $2,000; thus you would lose $3,000, or more
than half of your investment, if you decided to sell the stock. In
addition, you would have to pay compensation (a "mark-up,"
"mark-down," or commission) to buy and sell the stock. \1/4\
In addition to the amount of the spread, the price
of your stock must rise enough to make up for the compensation
that the dealer charged you when it first sold you the stock.
Then, when you want to resell the stock, a dealer again will
charge compensation, in the form of a markdown. The dealer
subtracts the markdown from the price of the stock when it buys
the stock from you. Thus, to make a profit, the bid price of your
stock must rise above the amount of the original spread, the
markup, and the markdown.
Primary offerings. Most penny stocks are sold to the
public on an ongoing basis. However, dealers sometimes sell these
stocks in initial public offerings. You should pay special
attention to stocks of companies that have never been offered to
the public before, because the market for these stocks is
untested. Because the offering is on a first-time basis, there is
generally no market information about the stock to help determine
its value. The federal securities laws generally require
broker-dealers to give investors a "prospectus," which contains
information about the objectives, management, and financial
condition of the issuer. In the absence of market information,
investors should read the company's prospectus with special care
to find out if the stocks are a good investment. However, the
prospectus is only a description of the current condition of the
company. The outlook of the start-up companies described in a
prospectus often is very uncertain.
For more information about penny stocks, contact the
Office of Filings, Information, and Consumer Services of the U.S.
Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549, (202) 272-7440.